Don't Shoot the Messenger

Trichet Announces New Rules For ECB Funding


In the photo above you can see European Central Bank President Jean-Claude Trichet welcoming Irish Finance Minister Brian Lenihan to the 10th anniversary celebration of the ECB, in Frankfurt on Monday, June 02, 2008.

Time To Stop The Abuse?

The ECB and the Spanish banks are back in the news today, following the decision by ECB president Jean-Claude Trichet to take advantage of his regular interest rate press conference to announce a number of funding rule changes affecting European bank access to ECB liquidity provision. These changes will affect all those financial entities that have developed an excessive dependence on the cheap “you can see my wallet if I can see your securities” funding which has been available up to now from the bank. The changes were judged by many analysts to have been slightly more radical than expected, and bank stocks in the Eurozone and the UK fell sharply on the news. Spanish and British banks fell the most, and HBOS Plc, the U.K. mortgage lender that has been tapping the ECB vaults via its Irish operation, fell 7 percent, while Barclays, the UK’s third-biggest lender, dropped 6 percent. Since the UK is not a member of the eurozone, this may give us some sort of measure of the kind of “abuse” which has many have long thought may have been occurring, but which was not evident due to the lack of transparency surrounding such operations. Other European banks who were “badly affected” by the news were the Swiss bank, and some smaller regional banks such as Erste Group in Austria and Piraeus Bank in Greece.

Ireland in the Forefront

What may well surprise many readers of this blog – although not perhaps after reading this post yesterday – is that it seems to be Ireland and not Spain which has been at the heart of most of the abuse (certainly you wouldn’t have known this from the number of articles in the popular press which have been busy pointing the finger at the Spanish banks though). Last week the ECB lenta total of 467 billion euros to European banks, or should I say to banks which have some sort of operating facility inside the 15-country euro area – although with banks like HBOS, UBS and even Australia’s Macqarie on the list, perhaps the term “European” is getting to be a bit stretched – and in return had been accepting a broader range of collateral to back the loans than the has been the case at Bank of England. Such collateral may include bonds with credit ratings five levels below AAA as well as asset-backed securities. The existence of this policy differential seems to have prompted a very mixed collection of non eurozone financial firms to create bonds specifically for use as collateral for ECB borrowing.

But when we look at how this money lent by the ECB has been allocated, then it may raise more than a few eyebrows to learn that lending to the much castigated Spanish banks has been “only” running at around 49 billion euros (as of July), while lending to Irish banks was running at 44.1 billion euros according to data from the Irish central bank in Dublin. I say only, since everyone is aware that Spain’s banks have a massive problem, so if a facility exists it is only natural that they use it (and I am not sure why this is called “abuse” since Spain’s savings banks in particular are under very great pressure, see below, so what are they supposed to do? Or put it another way, if people are so concerned about Spain why aren’t they asking why the ECB isn’t doing more to help? Certainly US banks don’t seem to be labouring under this kind of difficulty with the Federal Reserve).

To put what ahs been happening in perspective, since Ireland is about one tenth the size of Spain, it is as if the Irish banks had been accessing some 440 billion euros in funds. And things get worse, since about half of the funding from the ECB has been going of to the Dublin-based units of lenders from outside Ireland, according to analyst Eamonn Hughes at Goodbody Stockbrokers.HBOS, which has a unit in Ireland, is just one of the British banks that borrowed from the ECB, and hence the sudden drop in its share price yesterday. Earlier year it emerged Macquarie Bank had set up a deal backed by Australian car loans specifically for use at the ECB. But the whistle really was blown in mid August when the UK’s largest building society, Nationwide, got a lot of media coverage for saying it was planning to expand into Ireland to take advantage of “funding opportunities”.

So the first thing to have clear is that the real abuse of the ECB funding has not been coming from Spain, and Spain use of these funds has been more or less policed by Bank of Spain Governor Fernandez Ordoñez, with roughly half the funding going to Spain’s savings banks sector (who really do need liquidity, see below), but it is Spain’s banking sector who will take a big part of the hit, since while in other countries the funding may have been considered to be “froth on the daydream”, Spain’s banking system really is struggling.

The Measures Themselves

Trichet announced a series of measures, all of which had one feature in common: they will increase the cost of using asset-backed securities to obtain ECB funds. They will also now specifically exclude deals when the underlying mortgages or other loans are not denominated in euros.

Since the onset of the credit crunch in August last year the ECB has boasted its broad-based system had proved more effective than those of other central banks. But in recent months fears have intensified that banks could be exploiting the system by – for example – using riskier collateral than envisaged to get ECB funds.

The changes, which take effect from February 1, include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent. There will be penalties for asset-backed securities valued using computer models and for unsecured bank bonds. Banks will in fact have to take an initial markdown of 5 percent on any ABS that has been valued using a computer model. At the same time restrictions already in place on banks using assets they themselves had created were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital are quoted as saying that the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. “That could cost €375m to €450m annually to banks … Not in significant, but probably bearable,” according to BarCap analyst Laurent Fransolet.

The general opinion is that the changes will make it less attractive for banks to use asset-backed securities as collateral and will certainly push up the overall cost of borrowing funds from the ECB.

The asset class which will be most affected by the changes are ABS with a residual maturity of up to one year, which currently have a haircut of just 2 percent. Instead of receiving 98 euros in exchange for a security worth 100 euros, banks will in some cases receive just 83.60 euros under the new rules.

Spanish Savings Banks Will Be Affected

Spanish savings banks, such as Caja de Ahorros del Mediterraneo, are likely to be hit hard by the new rules, and this on the face of it seems to be most unfair, since if there has been abuse it is hardly towards them we should be looking given the already parlous state of their balance sheets. The savings banks, which are essentially non-profit lenders, accounted for almost 70 percent of the total growth in funds borrowed by Spanish financial institutions from the ECB over the last year, according to a recent research note from Banco Santander. Spain-based financial institutions borrowed 49 billion euros ($71.14 billion) from the ECB as in July, up from 18 billion over the same time last year, according to Bank of Spain data (so the savings banks have had approximately 21 billion euros in the last 12 months). Borrowing by Spain savings banks accounted for 4.4 percent of the 467 billion euro total funding from the ECB last week, up from 0.9 percent last year, according to the Santander research note issued yesterday. Regular Spanish banks increased their representation to 5.6 percent, from 4.6 percent.

Caja de Ahorros del Mediterraneo, which is based in Spain’s Valencia region, has been put on a watch list by ratings agency Standard and Poor’s, which said it could downgrade the bank by as many as two notches because of the fast deterioration of its asset quality. Spanish RMBS’s are currently trading in the secondary market at levels which vary between Libor plus 170 and Libor plus 350 basis points.

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